When one of the world’s largest and well-known investment banks was hit with a $550 million penalty for allegedly misleading investors, the financial world took notice. The prosecution of the vaunted Goldman Sachs firm can be interpreted as a sign that the Securities Exchange Commission and other regulators are taking a more aggressive position against banks and brokerage firms in light of recent legislative efforts and public outcries for financial reform.
In July, Goldman Sachs agreed to the settlement with the SEC after being charged with intentionally misleading investors in sub-prime collateralized debt obligations. The penalty is the largest ever assessed to a Wall Street firm by the SEC.
What Are Collateralized Debt Obligations?
Collateralized debt obligations (CDOs) are, according to Wikipedia, securities where “value and payments are derived from a portfolio of fixed-income underlying assets.” These fixed-income assets typically include mortgage-backed securities.
The problem with such securities began when banks loosened their lending standards and began to provide sub-prime mortgages to would-be homeowners who were high credit risks. These sub-prime mortgages then were sold and packaged into mortgage-backed securities so they could be traded on the open market. Thus, brokers and other finance professionals were selling risky securities to the investing public. Notwithstanding the significant inherent risk of many of these securities, credit ratings agencies generally gave these financial instruments distorted and favorable credit ratings. Because the investment banks paid the ratings agencies to issue the ratings, and thus provided the ratings agencies with their revenue stream, the ratings agencies (i.e. Moody’s, Standard & Poors) were beholden to the investment banks and were compelled to issue often-unjustified favorable credit ratings.
As part of the charges against Goldman Sachs, the SEC claimed that Goldman Sachs was preparing to bet against the very securities that it had structured and sold. Goldman Sachs denied any wrongdoing but said it made a mistake by providing incomplete information to its investors. Some would say that “providing incomplete information” is tantamount to fraud. This type of fraud falls under the umbrella of misconduct that involves misrepresenting or omitting material facts about an investment.
The SEC has more closely monitored banks in the aftermath of the financial meltdown. Some commentators claim that a lack of government regulation and rules enforcement led to questionable business practices, like the increase in sub-prime lending, as well as the proliferation of risky collateralized debt obligations sold to investors.
Will the half-billion-dollar Goldman Sachs penalty lead to across-the-board improvement in internal controls and standards? Will there be adequate disclosure for investors? Will there be transparency?
That remains to be seen.